Fundamental analysis of stocks is the analysis of demanding factors that affect the value of the stock. The intrinsic value of an equity share depends on an aggregation of factors. The earnings of the company, the growth rate, and the risk hazard of the company have a direct bearing on the price of the share.
These factors in turn rely on a host of other factors like the economic environment in which they operate, the industry they belong to, and companies’ performance. The appraisal of the intrinsic value of shares is done through this blog:
- Economic Analysis
- Industry Analysis
- Company Analysis
Table of Contents
Thus, fundamental analysis of stocks is a combination of economic, industry, and company analysis to obtain a stock’s current fair value and predict its future value.
This kind of fundamental analysis of stocks is also known as the ‘top-down approach’ because the analysis starts from an analysis of the economy, moves to industry, and narrows down to the company. This is also called EIC analysis (economy, industry, and company).
Stock valuation analysis
fundamental analysis of stocks: Economy analysis
Economic analysis is a component of fundamental analysis of stocks. it is the study of the general economic component that go into an evaluation of a security’s value. The stock market is an integral element of the economy. When the level of economic activity is greater, stock prices are high, reflecting a growing outlook for the sales and profits of firms.
An analysis of the macroeconomic environment is essential to understand the behavior of stock prices.
The generally analyzed macro-economic factors are as follows:
- Gross domestic product (GDP)
- Savings and investment
- Inflation
- Interest rates
- Budget and fiscal deficit
- Tax structure
- Balance of payments
- Foreign direct investment
- Investment by foreign institutional investors (FIIs)
- International economic conditions
- Business cycles and investors’ psychology
- Monsoon and agriculture
- Infrastructure facilities
- Demographic factors
Gross Domestic Product
The GDP represents the aggregate monetary value of the goods and services produced in the economy during a specific period. Although GDP is consistently calculated on an annual basis, quarterly estimates are also available. The frequent equation for the calculation of GDP is:
GDP = Consumption + Investment + Exports – imports
The growth rate of GDP points out the prospects for the industrial sectors and the return investors can expect from an investment in shares. A decline in the GDP demonstrates a potential economic slowdown. A high GDP growth rate is beneficial to the stock market.
The 1990s marked the initiation of the rise of the Indian GDP growth rate with the opening up of Indian markets to foreign direct investments (FDIs). Real GDP growth at factor cost increased to 8.5 percent in 2010-11 from 8 percent in 2009-10.
According to the RBI annual report (2010-11), the real GDP Growth rate increased for the second successive year after the global crises-induced a sharp slowdown in 2008-09.
Savings and Investment
Growth requires investment, which in turn, requires a extensive amount of domestic savings. Growth in savings naturally edge to more investments. High capital investment means the possibility of more production, more demand and supply, better prices in the future, and consequently, higher business profits and a positive outlook for the stock market.
Savings are distributed over different assets like equity shares, deposits, mutual funds units, real estate, and bullion. The primary market is a channel through which the savings of investors are provide to corporate bodies. Over the years, household and private corporate savings have increased and in turn, the gross domestic investment is also increased.
Inflation:
A simple explanation of inflation is that it refers to a situation where too much money is chasing a few goods. Inflation indicates a increase in the price of goods and services. Along with the growth of GDP, if the inflation rate also rise, then the real rate of growth would be very low.
Inflation and stock markets have a very convenient relationship. If there is inflation, the stock market is affected adversely. The price of a stock is directly related to the performance of the company. Inflation typically results in the following:
- High raw material cost
- Non-availability of low-cost credit due to rise in interest rates
- Low earnings
These factors hurt the stock prices and in return, there is a mild level of inflation, it is good for the stock market but high rates of inflation are harmful.
Interest Rates:
Interest rates have a direct bounce on the economy. The base rate of banks influences the cost of borrowed funds. The base rate is the minimal rate of interest at which banks lend to anyone.
It is the floor rate below which the RBI will not grant banks to lend. The base rate dimension for scheduled commercial banks for march 2011 was as follows
- Public sector banks – 8.25 to 9.50%
- Private sector banks – 8.20 to 10%
- Foreign banks – 6.25 to 11.75%
The base rate is alter by RBI’s bank rate, the repo rate, and the cash reserve ratio.
A decrease in the interest rate implies a low cost of finance and firms and more profitability.
More money is available allow-interest rest rate to brokers who do business with borrowed money. The availability of affordable funds encourages speculation and a rise in the price of shares.
An increase in lending rates affects negatively firms that depend on banks for their working capital and growth requirements.
Budget and fiscal deficit:
The budget draft provides a accurate account of government revenues and expenditures. A deficit budget may lead to a high rate of inflation and negatively affect the cost of production.
A surplus budget may result in deflation. A balanced is highly favorable to the stock market.
Fiscal policy is the difference between the government’s total receipts (excluding borrowing) and total expenditure. It can be expressed as follows:
Fiscal deficit = Total expenditure (revenue + capital) – (revenue receipts + non debt capital receipts).
The revenue deficit is the distinction between the government’s revenue expenditure and total revenue receipts (that is, tax and non-tax revenues excluding borrowing)
Tax Structure
Every year in march, the business community breathlessly awaits the statement from the government regarding the tax policy. Concessions and incentives given to a singular industry encourage investment in that particular industry.
The finance minister introduced tax exemptions for stock market investments in the Union Budget to attract retail investors to the stock market. There are a lot of schemes and policies made by the government to encourage investment in the stock market by the general public.
Balance of Payments:
The balance of payments is a record of a country’s money receipts from abroad and payments to foreign countries. The distinction between receipts and payments may be a surplus or a deficit. Balance of payments is a measure of the stability of the rupee on the external account.
If the deficit increases, the rupee value may deteriorate against other currencies, thereby affecting the cost of imports. Industries involved in exports and imports are markedly affected by changes in foreign exchange rates.
The volatility of the foreign exchange rate affects the investment of foreign institutional investors in the Indian Stock Market. A favourable payment has a positive effect on the stock market.
Foreign Direct Investment:
According to the International Monetary Fund (IMF), the definition of foreign direct investment (FDI) includes different components, namely, equity capital, reinvested earnings of foreign companies, inter-company debt transactions, short- and long-term loans, financial leasing, trade credits, the investment made by foreign venture capital investors and so on.
FDIs help in the upgrading of technology, skills, managerial capabilities, and much-needed capital to the economy. They also help in providing employment opportunities. The inflow of capital helps the economy grow and has a positive impact on the stock market.
Investment by Foreign Institutional investors (FIIs):
FIIs are considered to be the essential drivers of the stock market. The outflow of FII investment affects the stock market negatively.
International Economic Conditions:
Worldwide economies are not independent but interdependent. The boom or depression in one country influence other countries and the stock market. For example, the sub-prime crisis in the US bankruptcies, and a 29% drop in the Dow Jones and NASDAQ had an impact on the Indian Economy.
Business Cycles and Investors Psychology:
The business cycle contains four phases with different features, namely, Boom, Recession, Depression, and Recovery.
During a boom, economic activity is at its spike, and the growth of industry and GDP are prominent. Companies record higher turnover and profits. They engage in spread plans, mergers, and acquisitions.
This leads to investor optimism. Retail investors, big and small, are eager about the market and are willing to invest. The market reaches a new high.
Some of the companies may fail to fulfill the goals and as their profit margins fall, in the next phase of the trade cycle, a recession sets in. Economic growth declines, and there is an economic deceleration.
The stock market reacts with a decline in the price and volume of stock. Fear grips the market. The recession slips into depression. Result set in an additional fall in growth rates and an increase in unemployment. The investor becomes pessimistic about the market. Panic triumph and the stock market reaches a low level.
After a while, the economy slowly start recover. Some entrepreneurs begin to grasp that things cannot get any worse and start investing in the business. The recovery starts. In the stock market, the mood changes to desire and caution. Once again, the cycle goes on.
Monsoon and Agriculture
Despite technological advancements, Indian agriculture still depends heavily on monsoons. Good monsoons are a boon for agriculture. Agriculture is directly and indirectly related to many industries. For example, the sugar, cotton, textile, and food-processing industries associated upon agriculture for raw materials.
Farm equipment, fertilizer, and insecticide industries supply the aid used in agriculture. A favorable monsoon leads to a higher demand for these inputs, a bumper crop, and more disposable income in rural areas. This leads to elasticity in the stock market. When the monsoon fails, agriculture production and hydropower generation decline. They cast a gloom on the share market.
Infrastructure Facilities:
Good infrastructure facilities affect the stock market favourably. Infrastructure facilities are imperative for the growth of the industrial and agricultural sectors. A wide communication network is a prerequisite for the growth of the economy.
A regular supply of energy without any power cuts will enhance production. The banking and financial sectors should also be strong enough to give adequate support to industry and agriculture. In India, even though infrastructure facilities have been matured, they are not enough.
The government has liberalized its policies for the communication, transport, and power sectors. For example, the power sector has been opened up to foreign investors with guaranteed rates of return.
Demographic Factors:
Demographic data provide information about the population by age, occupation, literacy, and geographic location. This is needed to predict the demand for consumer goods. The population by age indicated the availability of a skilled workforce.
The cheap labor force in India has encouraged many multinationals to launch their ventures. Indian labor is cheaper compared to its western counterpart. Population, by providing employees and demand for products, affects the industry and the stock market.